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Capital Markets

Toxic funding

Manipulation of the stock prices of small, start-up companies can manifest itself in several ways. Genuine start-up companies are in need of investment, and illegal naked shorters can use their vulnerability and inexperience as a means of making money. Wes Christian, partner with law firm Christian, Smith & Jewell, says there tends to be two or three ways that these investors will loan a company money, and simultaneously short them out of existence using complicated financial arrangements – so-called toxic funding, or 'death-spiral financing'.

These financial scams involve a ring of investors who convince a small start-up company that they are interested in their company, product or idea. They can offer to loan the start-up $5 million, with a second-tranche promised of $25 million if the stock doesn't fall below, say $1. It sounds reasonable when your company's stock price is currently about $7. The ring of investors then begins to sell the company's shares, short-selling, slandering the company's name – anything to bring the share price down to below that $1 and avoid paying the $25 million. Once other investors see the start of a 'death spiral', they tend to jump ship, adding to the downward pressure on company stock.

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